The relationship between Price-to-Earnings (P/E) ratio and growth is a fundamental concept in valuation and investment analysis. Here’s a structured breakdown based on financial research:

1. Theoretical Relationship Between P/E and Growth

• The P/E ratio reflects how much investors are willing to pay per dollar of earnings.

• Growth (often measured as earnings growth) impacts P/E because higher growth expectations typically lead to higher valuations.

A widely used formula to approximate this relationship is derived from the Gordon Growth Model (Dividend Discount Model for a firm with constant growth):



where:

•  = retention ratio (1 - dividend payout ratio),

•  = required rate of return (cost of equity),

•  = expected growth rate in earnings.

This equation suggests that as earnings growth (g) increases, the P/E ratio also increases, provided that the required rate of return remains constant.

2. Empirical Findings from Research Papers

• Fama & French (1992, 1995): Their studies indicate that while growth is a factor in valuation, P/E ratios tend to be more correlated with risk factors (such as market beta and size) than pure earnings growth.

• Lynch (1990) – PEG Ratio: Peter Lynch popularized the P/E-to-Growth (PEG) Ratio, which suggests that a P/E ratio should roughly match earnings growth for fair valuation. A PEG ratio of 1 is considered optimal (i.e., a company with a P/E of 20 should ideally have 20% growth).

• Chan, Karceski & Lakonishok (2003): Found that high P/E stocks tend to underperform over time because market expectations about growth are often overly optimistic.

• Asness (2000): Examined the link between P/E and future stock returns and found that high P/E stocks often experience lower-than-expected growth, leading to mean reversion in valuations.

3. What is the Optimal P/E-to-Growth Relationship?

• The PEG ratio rule (PEG = 1) is a simple heuristic but doesn’t work in all cases.

• Research suggests that:

• High-growth stocks justify higher P/E ratios but are at risk of overvaluation.

• Low P/E stocks with stable growth often generate better long-term returns due to value investing principles.

• Earnings stability and predictability (low volatility in growth) support higher sustainable P/E ratios.

• Industry and macroeconomic factors must be considered—tech stocks, for example, typically trade at higher P/E due to innovation-driven growth.

4. Practical Takeaways

• For mature companies, P/E should align closely with long-term sustainable growth.

• For high-growth firms, excessively high P/E can indicate overvaluation unless backed by strong fundamentals.

• Optimal P/E depends on risk-adjusted growth, meaning that a high-growth but high-risk company should have a lower P/E than a high-growth, low-risk firm.